Lessons From The East

30/09/2011 at 11:47 am

Among the many spectres raised to justify the current bear market, one of the most persistent is that of deflation. Some central banks, too, have referred to this unspeakable terror in an effort to legitimize their more exotic recent policy action. We had a look at the dove argument on inflation three weeks ago and challenged its tenets then. When it comes to outright deflation, however, we can also invoke the experience of Japan and ask the question: how close are other developed nations to a similar state?

To recap: Japan’s economy has been through hell since the collapse of the 1980s economic and investment boom. The stock market crashed in 1990, growth began to slow, and the Bank of Japan cut rates accordingly. The yen, however, was allowed to appreciate by over 50% on a trade weighted basis at the same time, more than compensating for this effect and ensuring a recession which saw growth move sideways for two years. This accelerated the pace of decline in the property market, which contributed to a major financial crisis.

Another period of massive yen appreciation followed in the wake of the collapse of the Asian tiger economies, which together with the collapse of the TMT boom saw the level of Japanese real GDP move sideways for five years this time (1997-2002). A period of respite followed – until the latest banking crisis, stock market crash, and now the earthquake of this year which has plunged the economy into recession yet again: the fifth episode of negative real year-on-year GDP growth in twenty years, which has seen the economy contract to its level of six years ago. Over the last two decades as a whole, real growth has averaged a barely perceptible annual rate of 0.7%.

Even with that cataclysmic, catatonic performance, persistent and significant price deflation has only occurred alongside the more savage contractions in growth. The nationwide CPI moved about 4% lower peak to trough after the 1997 collapse, and remained pretty stable thereafter until the credit crunch (so delivering annual inflation of zero, rather than deflation per se). This time it sank about 2% from end-2007 to end-09, since when it has again remained flat.

A diehard bear might well argue that a similar experience awaits the terminally doomed economies of the US and Europe. So rather than argue, let’s look at what this contractive, deflationary backdrop has meant for Japanese asset prices.

Interest rates have averaged 0.25% over the last ten years, decimating returns to cash. 10 year bond yields have averaged 1.4% over the same period (and traded in a range of about 1-2% since 1997). Equities have been rangebound too, though it is worth noting that the Nikkei rose to a peak 132% above its post-dotcom low in 2007, while the S&P 500 managed a mere 90% in comparison.

All of which suggests to this blog that cash rates and bond yields are already pricing in the Japanese experience across most of the developed world. Equity markets are the exception: while they are close to their 20-year lows, their valuations are way below Japan’s. (In the middle years of the last decade, the p/e on the Nikkei drifted around 30-40x – an earnings yield of 2.5-3.5%, which looks low but was generous relative to other classes of asset).

In other words, asset prices at present suggest the fear of something even worse than Japan’s lost decades. It’s arguable whether such a reality could possibly exist. But you can’t argue that it’s a properly bearish view.


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